“The market predicts the economy; the economy does not predict the market,” wrote Ben Miller of Miller Value Partners in his 10 July letter to investors. This simple truth, he argues, is the problem with those who believe US stock prices have become detached from reality.
Annual economic growth and stock prices have only had a correlation coefficient of .09 from 1930 through to 2019, a stat Mr Miller quotes to make his point that investors pay for what they think a company can make in the future, not how it is doing now.
The question investors should be asking is whether the optimism is well placed. Since Mr Miller published his letter, rising Covid-19 death tolls in America’s sunbelt have given cause to doubt a V-shaped economic recovery and the rapidly approaching elections bring more uncertainty.
Bulls can point to some impressive recent earnings beats by the likes of Microsoft (US:MSFT) and Tesla (US:TSLA), a stalwart of quality growth and poster child of speculative growth investing strategies, respectively.
Then there is the ultra-dovish Federal Reserve, creating hundreds of billions of dollars to puff up asset prices and sign-posting that it has no intention of raising interest rates for years.
As Howard Marks of Oaktree Capital put it in his second-quarter note (written before the sunbelt Covid-19 spike): “With the outlook now positive, investors likely concluded that they no longer needed to insist on the generous risk premiums afforded by low entry prices, meaning purchase prices could rise.”
The trouble with the market’s assumptions
Framing the discussion another way, the market hasn’t necessarily lost touch with reality, rather that reality is now driven by falling discount rates and not fundamentals. Yet companies must still deliver earnings growth and the market is placing extreme expectations on a few quality businesses.
Citing a report by Empirical Research on the phenomenon of the “Big Grower”, David M Poppe of Giverny Capital weighs in with his assessment of market rationality.
Based on Goldman Sachs’ expectations that S&P 500 earnings will decline 24 per cent in 2020 and recover 31 per cent in the next year, Mr Poppe concedes that – so long as 2021 earnings rebound to 2019 levels as implied – it’s not obvious the market is wrong.
Empirical Research shows, however, that even amongst companies expected to grow revenues, there is great dependence on a concentrated few to increase earnings.
Their study identified 75 stocks with exceptional revenue and share price momentum. The combined market cap approached $7 trillion and the group traded on 71 times forward earnings estimates. That’s a long multiple but subtract the largest companies and the bet on profits growth is even starker.
Microsoft and Apple (US:AAPL) weren’t in the 75, but Amazon (US:AMZN), Alphabet (US:GOOGL) and Facebook (US:FB.) were. Take them out and the remaining 72 (market cap $4 trillion) are nowhere near as supported by trailing earnings and free cash flow, with 22 of the growers losing money.
The market, writes Mr Poppe, seems to say that today’s earnings don’t matter because the future trajectory is so clear. The median company on the Empirical Research list has generated 30 per cent annual revenue growth over the past five years and the pandemic has amplified investor interest in businesses that cater to working, shopping and playing at home.
Changes in the way people live may well be accelerated thanks to Covid-19, but the mathematics for investors is still daunting. Empirical says Wall Street analysts expect median Big Grower earnings to grow at a compound annualised rate of 22 per cent over five years, and 13 per cent over 10 years.
To put that in perspective, Mr Poppe highlights that over the past 60 years about 30 per cent of the 75 fastest growers in any given year achieved at least 13 per cent earnings growth for the following decade. Yet the market is saying the next ten years will see half of companies achieve this.
In only one decade, the 1960s, have half of the 75 fastest growers maintained over 13 per cent a year and that was when US gross domestic product (GDP) expanded at a real rate of 5 per cent. In the 2020s, Mr Poppe writes, US GDP may not grow half as fast.
But don’t fight the Fed…
The one overarching rational force behind the second-quarter rally was the sheer scale of money creation by the Fed, which has signalled it will not step back from supporting bond markets, both in US Treasuries and credit. Inevitably, with yields suppressed, money is finding its way into equity markets, keeping share prices sky-high.
Ensuring the functioning of the financial system is the Fed’s core remit and it speaks volumes that America’s central bank is seeming to settle for avoiding systemic collapse over markets that allocate capital efficiently.
Mr Marks writes: “…there’s no reason to believe the Fed insists on good value, high prospective returns, strong creditworthiness to protect it from possible defaults, or adequate risk premiums.
Rather, its goal seems to be to keep the markets liquid and capital flowing freely to companies that need it. This orientation suggests it has no aversion to prices that overstate financial reality.”
Really, Fed Chair Jay Powell and the rest of the open markets committee who set monetary policy, have an impossible task. Coronavirus is a black swan event that has strangled the cash flows of otherwise well-run businesses. Without access to the Fed’s refinancing facilities they would be going to the wall in greater numbers.
Bad companies whose interest costs would have exceeded cash profits anyway are kept alive too, which is an unhealthy consequence of the emergency measures. “Zombie companies (debt service > Ebitda) and moral hazard don’t appear to trouble the Fed,” writes Mr Marks.
Although this assessment is harsh, he is right that indiscriminate support will be bad for the economy if continued indefinitely.
Textbook economics explains the effectiveness of monetary policy even as the real economy struggled in the second quarter. Unlike in 2008-09 when it took the Fed a while to marshal enough firepower to end the financial crisis, Mr Miller says the immediate and overwhelming response this time brought the equation of exchange into play.
Money supply multiplied by the velocity with which it is spent is equal to the price times the quantity of goods sold: MV=PQ is the equation. “The pandemic and economic shutdown led to a collapse in money velocity as there was little to spend money on with so many businesses closed,” explains Mr Miller.
“Other things equal, P or Q or both would then collapse with velocity. PQ is equivalent to nominal GDP. So the Fed responded by expanding the money supply, at a record pace.”
“Some of that money is making its way into the real economy and the data indicate economic activity bottomed in the second quarter and things are improving. It also made its way into the markets, helping to lift stocks.”
Can the Fed keep propping up markets?
In its recent update, Epoch Investment Partners noted that the Fed’s main concern is unemployment and highlighted that even with the gargantuan bond purchases made this year, the share of US government debt held by the central bank is still low as a proportion compared with peers.
Therefore, they argue, the Fed will see plenty of scope to keep expanding its asset purchase scheme with monetary policy likely to focus on yield curve control to manage the ballooning debt.
Although the Fed’s willingness to expand its balance sheet is seemingly unlimited, Epoch points to evidence that the marginal effectiveness of this largesse is diminishing. Furthermore, they say, evidence from Europe and Japan points to an increase in debt hindering rather than boosting growth.
Longer term, it seems the impact of zombie companies is to crowd out better run businesses which, if week competition doesn’t die, won’t win the market share their superiority warrants. This means the economy is less creative, dynamic and full of too many sluggish performers which in turn acts as a drag on productivity and the velocity of money.
If we’re witnessing the slowdown of big tech, where can investors look for positive returns?
Although the so-called 'Fed put' has seen stock prices rise, the longer-term outlook for GDP growth looks weak, which implies challenges for the 75 Big Growers in continuing to build revenues and deliver consistent profits growth to justify their valuation.
Growth investors have had a phenomenal run since 2009, but although the tech giants that have driven S&P 500 earnings growth are still great businesses, their next leg up will be priced in. The reaction to Microsoft’s full-year results was revealing. Although it delivered revenue and earnings beats, a fall in the rate of cloud user growth was enough to send its share price lower.
That shows how valuations of super quality shares are on a knife edge. Investors are nervy at any sign of future disappointment, good news is already priced in and even if all business indicators and financial results are as expected, just a slight uptick in inflation and interest rates will mean share prices have to fall to imply a fair real value for the company’s future cash flows.
Value investing has been seriously out of vogue for many years – and the first half of 2020 has seen the style underperform spectacularly – but as Bill Gross explains in his 'The Real Deal' newsletter in July, value investors acknowledge the importance of real interest rates.
One reason Mr Gross offers for the erstwhile outperformance of growth stocks is that the price of dependable growth stocks is significantly influenced by a declining real interest rate. The market assumes Amazon or Microsoft will maintain a consistent future growth rate, so when the price of Treasury Inflation Protected Securities (Tips) rises and their yield goes down, the value of these tech stars shoots up.
The plunge in long-term real interest rates has impacted the share price of Apple and Amazon significantly, says Mr Gross, but the effect has been much less for cyclical and value-oriented stocks because their expected growth rates have fallen too.
Has the low rate tailwind for quality stocks seen its best days? Mr Gross thinks so, and he points to the 10-year U.S. real rate, at minus 75 basis points, approaching the inflation-linked bond yields of Germany and Japan. He notes the only buyers for these securities are governments and regulated pension funds, “which incredibly mandate their purchase for portfolios”.
Perhaps this last point presents the flaw in his argument, however. The presence of forced buyers suppresses yields and there is no forced buyer like the Fed, which as well as lubricating a financial system with an insatiable thirst for dollars, is also creating the money to lend to the U.S. government to fund its enormous fiscal support programmes for the economy.
Nevertheless, Mr Gross is right to highlight that investors should be looking at the fact of real interest rates as well as hoping for future earnings upgrade forecasts. In the absence of the latter, big tech’s relative outperformance of lesser growth but still high quality stocks such as Coca Cola (US:KO) and Procter & Gamble (US:PG), depends on continued trust in existing forecasts and ongoing decline in real rates.
Evidence that value investing tools should not be forgotten when assessing growth stocks – after all, what you pay for something matters – is found in Microsoft’s past share price movements.
Described by Mr Gross as “perhaps the most consistent growth stock of all” in terms of its expected growth rate, he identifies Microsoft’s share price as having a .854 r-squared correlation to the price of Tips securities in the past two years. When Tips prices go down (i.e. when real yields, that move inversely to price, go up), Microsoft goes down in the subsequent few days.
Correlation is not to be confused with causality though, and Mr Gross acknowledges higher growth, momentum and the effect of index funds have provided for a share of the appreciation. He estimates, however, that Tip rates dropping nearly 200 basis points in two years could account for half Microsoft’s share price increase.
“Would I bet the farm on this correlation in the future?”, he asks rhetorically, “Well maybe 40 acres worth.”
Taking the right risks
Overall, Mr. Gross prefers value stocks over the “Fab Five” tech stocks – Microsoft, Apple, Alphabet, Facebook and Amazon – but the companies he touts on his watchlist all have their own idiosyncratic risks.
He names oil & gas pipeline services business Enterprise Products Partners (US:EPD); tobacco firm Altria Group (US:MO); computer business IBM (US:IBM), which is repositioning itself to compete in cloud computing and artificial intelligence technology; and pharmaceuticals company AbbVie (US:ABBV).
High-conviction value investing has been waiting what seems like an eternity to come good, however. Many have been burned trying to time a style rotation from growth to value stocks and it seems prudent to re-weight portfolios rather than totally exit positions in quality businesses.
Being out of the best tech stocks was the biggest opportunity cost for Distillate Capital, even though its investing strategy outperformed in the sharp market decline as well as in the recovery.
Being shy of exposure to Amazon’s 49 per cent Q2 gain subtracted 1.7 per cent from Distallate’s relative performance. Missing gains from Netflix (US: NFLX), Paypal (US:PYPL), semi-conductor business Nvidia (US:NVDA) and Microsoft cumulatively cost 1.6 per cent against benchmark.
Distillate’s strategy might be loosely described as quality-value investing – it seeks to invest in the 100 most attractively valued stocks with high levels of long-term fundamental stability and low leverage. Star performers in the last quarter included Regeneron Pharmaceuticals (US:REGN) and software specialist Citrix Systems (US:CTXS), and they also did well from holdings in Procter & Gamble and Abbvie.
Clearly, such a strategy isn’t light on quality but there is no need to risk missing out if there is further upside for big tech. Giverny Capital’s Mr Poppe says his fund owns six companies on the list of 75 Big Growers, three of which are Alphabet, Facebook and Amazon.
The other three are Mastercard (US:MA), computer communications business Arista Networks (US:ANET) and discount stores chain Five Below (US:FIVE). At the time of Mr Poppe’s note, all of them were profitable and traded at less than 21 times analyst estimates of 2024 earnings.
Facebook’s second-quarter earnings were published on 29 July and Alphabet's a day later, but at the time of Mr Poppe’s letter they traded on 13 times their 2024 earnings estimates. Of course, both are vulnerable to a downturn in ad spend and in a US election year, Facebook in particular is subject to scrutiny and high costs of moderating content, but Mr Poppe’s hope was that in aggregate his six growers would need two or three years to become reasonably priced, not ten.
The elephant in the room (or will that be the Democrat donkey after November) is, of course, the rising cases of coronavirus in America’s western and southern states. Along with everyone else, money managers have taken up armchair virology and despite some convincing arguments that the disease break point may be lower than the threshold required for herd immunity, nobody really knows – and the recent data on cases and deaths is heading in the wrong direction.
Unfortunately, this has been the most politicised pandemic in history and the narrative around the disease is hugely damaging to the economy even if the medical situation is manageable. Then there is the ongoing geopolitical risk as America’s relations with China worsen.
Until the election, it may be that the momentum trade is no longer stocks but continues to be gold. Unlike the professional money managers who are expected to be invested, retail investors might also want to keep some powder dry and hold more cash. Despite the need for caution, however, the breadth of quality companies on offer means it doesn’t pay to be out of US stocks entirely.
As far as a US equities strategy is concerned, the way forward is perhaps to invest away from market capitalisation weighting so the focus isn’t too skewed to the most expensive companies. In other words, don’t ditch tech but underweight it to benchmark and increase the weight of value approaches but consider quality safeguards. Of course, that’s easier said than done, but the task is less difficult with US shares compared to the UK market.
